1. Frederic S. Mishkin

The issue that Susan Collins addresses in her paper is whether the buildup of net
foreign indebtedness from current account deficits requires a policy response
to eliminate these deficits. I am an outsider to this debate with my area of
expertise focussing on issues of how monetary policy should be best conducted.
In the past, I have committed in print to the proposition that the two main
goals that a central bank should pursue are price stability and financial stability.
One question raised by Susan's paper is whether a central bank should pursue
a third goal in the conduct of monetary policy: the elimination of current
account deficits. Susan's answer for Australia is no, although she does
hedge her bets a little bit by indicating that in some situations, as in the
case of Japan during the postwar adjustment years from 1953–1964, using
monetary policy to manipulate the current account may not have been a bad policy.
I, on the other hand, want to come down much stronger against the use of monetary
policy to manipulate the current account: under no conditions should the monetary
authority focus on the current account as a target of its policy.

Before I go on to discuss how policy makers should respond to current account deficits,
I do want to discuss some methodological issues about the approach used by
Susan in her paper.

The Case Study Approach

Susan's paper uses the case study approach to look at whether persistent current
account deficits for other countries in Asia have created serious problems
for their economies. The evidence in Susan's paper indicates that the answer
is no. Her studies of Asian countries, particularly South Korea and Indonesia,
show that current account deficits are often necessary to keep domestic investment
high, even when there is a shortfall in domestic savings, and can therefore
be an important part of a virtuous cycle which promotes investment and growth.

I found Susan's case study evidence to be extremely informative and useful, and
I think that it convincingly demonstrates that current account deficits do
not have to lead to problems. My only criticism of her analysis is that by
focussing on Asia, she only has looked at countries that have been a success
story. To fully assess what problems might arise from persistent current account
deficits, we would also want to look at countries with high deficits who eventually
r an into difficulties. Specifically, it would have been worthwhile for the
paper to have contained some discussion of the Latin American experience. As
we know, Latin American countries incurred large current account deficits in
the 1970s, but were unable to repay their foreign debt in the 1980s, leading
to severe dislocations for their economies. The Latin American episodes suggest
that there is not always a happy ending when a country has a large buildup
of its foreign indebtedness.

My impression is that the key element of the Latin American debt problem was that
the foreign debt was incurred by the government and not the private sector.
Thus the incentives to borrow only for productive investment opportunities
were not strong and, at least on an ex post basis, over borrowing resulted. Since Australia's
foreign debt has been primarily incurred by the private sector, it is not at
all clear that Australia's situation is at all comparable to that in Latin
America. Nonetheless, I would have liked the paper to contrast what happened
in Latin America with what occurred in Asia, thereby helping us to see when
persistent current account deficits might get a country into trouble.

Are Current Account Deficits a Problem for Australia?

Many economists, politicians and members of the media have a knee-jerk reaction that
current account deficits which lead to substantial net foreign indebtedness
must be bad. However, taking the view that foreign indebtedness is bad is like
taking the view that any indebtedness is bad. Clearly borrowing can be a bad
thing if there are the wrong incentives (bad tax policy, government guarantees,
etc.) encouraging individuals and firms to borrow too much. Nonetheless, it
must always be remembered that borrowing helps drive economic growth. The key
role of financial markets in a successful economy is to promote borrowing:
that is, financial markets move funds from those with a surplus to those with
a deficit who have productive investment opportunities. If the borrowing channel
were to be cut off, these productive investment opportunities would never see
the light of day, thus making for an inefficient and slow growing economy.

This view of borrowing leads me to the following position. In order to make the case
that current account deficits are a problem, you must demonstrate which incentives
are wrong that either promote too much investment or too little saving. The
standard criticism of current account deficits is that the net indebtedness
they create will have to be paid back by lowering standards of living in the
future. However, if foreign borrowing was used to make a productive investment,
the result will be that output will grow so much that consumption in the future
will rise even after the loans are paid back. Susan's discussion indicates
that this seems to be the case for
South Korea.
However, current account deficits may be a problem for Australia. Susan finds that,
in contrast to South Korea, net foreign indebtedness for Australia is associated
with a future real depreciation of the
Australian dollar. Because, in contrast to the Latin American countries
who experienced a debt crisis, Australia's foreign debt has been incurred
by private firms rather than the government, it is not obvious that there are
distortions that have promoted overborrowing and over investment. Indeed, looking
at the recent figures for Australian investment, it seems far more likely that
there is a problem of under investment rather than over-investment.

However, there is reason to be concerned that Australia is undersaving. Australian
savings rates are well below the other countries in Asia that Susan has looked
at and there are reasons to believe that government policies have not given
consumers the right incentives to save. For example, while the Australian government
pension scheme may be highly justifiable on equity considerations, because
it is given to old people only if they do not have enough income or assets,
it discourages private saving. Also the reliance on income tax rather than
a consumption tax to raise revenue also produces disincentives for private
saving. There is also concern that Australian government budget deficits may
remain high even after the economy strengthens, thus leading to government
dissaving which also contributes to undersaving.

Implications for Policy

The key conclusion from Susan's paper and from the above discussion is that current
account deficits do not automatically indicate that there is a problem that
requires changes in government policy. Yet, this does not mean that current
account deficits should be ignored because they might signal that incentives
to save and investment may be incorrect, requiring a change in policy. The
key point for policy making is that once a government's fiscal house is
in order, the solution to a problem of an inappropriately high current account
deficit is to create the right private incentives for savings and investment.
This requires focussing on what distortions in private markets might be leading
to non-optimal amounts of savings or investment, and then deciding how these
distortions can be eliminated or, alternatively, offset by other microeconomic
policies.

For example, evaluation of the incentives for dissaving arising from the Australian
government pension system might indicate that superannuation contributions
should be raised in order to get people to save the appropriate amount for
retirement. By using superannuation to compensate for the distortion created
by the government pension system, private saving would be closer to the optimal
level and the current account deficit would shrink. Forced savings for retirement
indeed has been part of the policy package in Singapore which raised savings
rates and helped reduce current account deficits. An important point about
this kind of policy response is that it does not focus on the current account
deficit per se. Instead it identifies a distortion in the market
and then tries to correct the distortion with microeconomic policies.

An inappropriate policy response to current account deficits is one which assumes
that all such deficits are bad and thus require policies to either directly
lower investment or raise savings to hit a target for the current account deficit.
The use of monetary policy to hit current account deficit targets is exactly
one such inappropriate policy response. Susan points out that using monetary
policy to eliminate current account deficits wouldn't work very well for
an open economy with flexible exchange rates like Australia. The usual story
is that a tighter monetary policy reduces the current account deficit by raising
saving and lowering investment. However, in an open economy with flexible exchange
rates, the tighter monetary policy leads to an appreciation of the domestic
currency which has offsetting effects on the current account. The result is
that it is not clear whether a tightening of monetary policy will lower or
raise the current account deficit.

I want to make the case against using monetary policy to deal with current account
deficits even stronger. Under no conditions should monetary policy be used
to eliminate current account deficits. The case against using monetary policy
to reduce current account deficits applies equally well to closed economies
with fixed exchange rates like Japan in the 1953–64 years as it does
to an open economy with flexible exchange rates. Indeed, I feel that Susan
gives too charitable a view of Japanese monetary policy in this period.

The idea that monetary policy can be used to deal with current account deficits is
based on an old Keynesian fixed-price framework which is now thoroughly discredited.
In this framework, tight money raises both nominal and real interest rates
(because prices are fixed) which lead to a decrease in investment and an increase
in savings that lowers the current account. However, in a world of flexible
prices, although monetary policy can control real interest rates in the short
run, it cannot control real interest rates in the long run. The inability of
monetary policy to control real interest rates in the long run is just an implication
of long-run monetary neutrality in most standard flexible price macro models.
Since monetary policy cannot control real interest rates in the long run, it
cannot be used to correct a long-run structural problem of an imbalance between
savings and investment.

The attempt to use a policy which only works in the short run but not in the long
run only results in a stop-go policy like the one pursued by Japan in the 1953–64
period. It should be said that although Japanese monetary policy was based
on inappropriate principles, it did not do too much damage to the economy.
Luckily, Japan developed high savings during this period so that there was
no large structural imbalance between savings and investment which required
a permanent contraction of investment and the economy in order to satisfy the
current account target.

Although I have criticised the use of monetary policy to reduce current account deficits,
I want to be careful to point out that inappropriate monetary policy which
produces inflation may create distortions in the economy which lead to large
current account deficits. Thus, I am wholeheartedly in agreement with Susan's
conclusion that prudent macroeconomic policies are an important element in
keeping current account deficits from becoming a problem for a country. Keeping
its fiscal house in order and not running large budget deficits is one element
of prudent macroeconomic policies. The other elements are maintaining price
stability and financial stability so that financial markets function properly,
with the result that private investment and savings are optimal. Thus I am
left holding to my earlier position that the monetary authorities should not
focus on the current account but should stick to preserving price and financial
stability.

2. General Discussion

The discussion centred on various aspects of Australia's current account experience,
but also touched on some of the examples from Asian countries discussed in
the paper.

For Australia the focus was on two related issues. The first was whether the size
of the current account deficit, and the level of foreign debt, were problems.
The second concerned the causes of the imbalance between savings and investment.

One participant argued that Australia's level of foreign liabilities, and its
continuing current account deficits, represented a serious problem. If the
international market becomes reluctant to continue financing investment in
Australia, the low level of Australian savings was thought to condemn future
generations to declining relative, and perhaps absolute, living standards.
Even if Australia continues to attract foreign savings, the increased foreign
debt will cause the real exchange rate to depreciate in order to generate the
trade surpluses necessary to service the foreign liabilities.

This pessimism was not universal. One participant argued that Australia typically
devotes a higher share of GDP to investment than many OECD countries. While
Australia's relatively fast population growth accounts for part of its
high investment, it does not account for it entirely. This investment is being
used to create the productive capacity to service the debt without the need
for real depreciation. In addition, the process of internationalisation is
probably increasing the economy's growth rate, so that there is little
reason to believe that the current foreign debt is going to saddle future generations
with stagnant or declining living standards.

Most participants suggested that the current imbalance between domestic savings and
investment was probably not optimal. Three reasons were cited. First, some
saw government savings as too low. An increase in the structural budget deficit
may have been warranted in the early 1990s, but there was a feeling that the
government was not winding back the budget deficit quickly enough. However,
it was also remarked that it might be difficult to maintain the quality of
government spending, while reducing the deficit, so that there was a trade-off
between quality and size. Nevertheless as investment levels rise, the failure
of government savings to increase significantly may lead to a substantial increase
in the current account deficit.

Second, when taking account of opportunity costs, the private savings rate can be
too low. Even if this is not caused by policy-induced distortions, it is a
policy problem. The existence of policy-induced distortions affecting private
saving was seen as the third reason why the savings-investment imbalance may
not be optimal. While one way to increase total savings was to remove the distortions,
in some cases the distortions were important tools of social policy. Here,
the pension system was seen as very important. By guaranteeing payments from
the government after retirement, the pension system discouraged individuals
from saving sufficiently. Given that removing the social safety net was undesirable,
the discussion turned to other policies that could be used to prevent the pension
system from unduly distorting the aggregate savings outcome. Here, compulsory
superannuation was thought to be particularly important. Changes in taxation
were generally seen to be less effective in generating additional saving, as
most saving was done for retirement. Given the continued existence of the safety
net, changing incentives through taxation was thought to be inferior to compulsion.
However, not all participants were in favour of compulsion, as it restricted
individuals' rights to make their own decisions. There was no disagreement
with the proposition that monetary policy was an inappropriate tool to target
the current account deficit.

In reference to the Japanese experience, it was argued that the combination of a
fixed exchange rate and a lack of access to world capital markets forced the
authorities to use monetary policy to keep the current account in balance.
There was also some discussion as to whether increased growth led to higher
savings, or higher savings led to faster growth. A number of participants made
the case that various countries experienced high investment rates and high
current account deficits initially but then, as the growth dividend from the
investment began to be realised, savings rates rose. In addition, in a number
of countries, policies designed specifically to increase savings were initiated.
There was some question as to whether these schemes did in fact increase savings
rates. The example of Singapore was given where the Central Provident Fund
appears to have contributed to the national savings rate of over 40 per cent
of GDP, though it is not the only policy. In Malaysia, savings may have also
been strengthened by policy measures, while the effects of such measures in
Thailand were said to be uncertain.